The Global Treasury Market Is Under Pressure As Fed Raises Rates

The next Fed crisis has begun. Unlike 2008, where “subprime mortgages” freezes counter-party trading in credit markets since Lehman Brothers failed, in 2022, it could be the $27 Trillion Treasury market.

When historians review 2022, many will remember it as a year of nothing. It’s a lot different than what people think it’s going to be.

Throughout the year, rising interest rates, Russia’s invasion of Ukraine, rising energy costs, inflation running at its highest level in 40 years, and the withdrawal of liquidity from stocks and bonds have been brutal. hit the markets. Since the 1980s, bonds have been the defacto hedge against risk. However, in 2022, bonds suffered their worst fall in more than 100 years, with a 60/40 stock and bond portfolio returning a staggering -34.4%

The drawdown of bonds is the most important. The credit market is “life blood” in the economy. Now, more than ever, economic activity requires constant increases in debt levels. From corporations issuing debt for stock buybacks to operations to consumers leveraging to sustain their standard of living. The Government needs the continuous issuance of debt to finance spending programs because it needs the total tax revenue to pay social welfare and interest on the debt.

For better perspective, it currently needs more than $70 Trillion in debt to keep the economy going. Before 1982, the economy grew faster than the debt.

Debt issuance is not a problem as long as interest rates remain low enough to sustain consumption and there is a “buyer” for debt.

A Lack of a Marginal Buyer

The problem comes when interest rates rise. Higher rates reduce the number of willing borrowers, and mortgage buyers balk at lower rates. The latter is the most important. If debt buyers disappear, the ability to issue debt to finance spending becomes more of a problem. That’s the point Treasury Secretary Janet Yellen made recently.

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“We are concerned about the loss of sufficient liquidity in [bond] market.”

The problem is that the outstanding debt of the Treasury has increased by $7 trillion since 2019. However, at the same time, the major financial institutions that act as the “main sellers” do not want to serve as net buyers. One of the main reasons for this is that over the past decade, banks and brokerages have had ready buyers from whom they can offload Treasuries: The Federal Reserve.

Today, the Federal Reserve no longer acts as a willing buyer. Because of this, the primary dealers do not want to buy because no other party wants the bonds. As a function, liquidity in the Treasury market continues to take off. Robert Burgess sums it up nicely:

“The word “crisis” is not hyperbole. Liquidity is quickly evaporating. Volatility is rising. Once unthinkable, even the demand for government debt auctions has become a concern. The conditions are so worrying that Treasury Secretary Janet Yellen took the unusual step on Wednesday of expressing concern about a potential trade collapse, saying after a speech in Washington that her department was “concerned about the loss of sufficient liquidity” of $23.7 trillion. market for US government securities Make no mistake, when the Treasury market seizes up, the global economy and financial system have bigger problems than high inflation.

This is not the first time this has happened. Every time the Federal Reserve has previously raised rates, it has tried to stop “quantitative easing,” or both, a “crisis event” happened. Such requires an immediate response by the Federal Reserve to provide a “accommodative policy.”

“All this comes as Bloomberg News reports that the biggest, most powerful buyers of Treasuries, from Japanese pensions and life insurers to foreign governments and US commercial banks, are all back at the same time.’We need to find a new marginal buyer of Treasuries because central banks and banks in general are in the rest phase. – Bloomberg

It’s Not a Problem Until Something Breaks

As mentioned before, while there are actuals “Warning signs” in the weakness of the financial markets, they are not enough to force the Federal Reserve to change monetary policy. The Fed noted as much in recent meeting minutes.

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“Many participants noticed that, especially in the current less certain global economic and financial environment, it is important to calibrate the pace of further policy tightening with the aim of reducing the risk of significant adverse effects. from an economic point of view.”

While the Fed is aware of the risk, history suggests the “Crisis level” necessary for a change in monetary policy will remain at a distance.

Source: Bank Of America

Unfortunately, history is littered with monetary policy mistakes where the Federal Reserve over-tightened. As markets rebel against quantitative tightening, the Fed will eventually agree to sell the flood. The destruction of “wealth effect” threatens the movement of equity and credit markets. As I will discuss in an upcoming article, we are already seeing the first cracks in the currency and Treasury bond markets. However, volatility is rising to levels where it was before “events” happened.

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As stated in “Inflation Becomes Deflation,” The main threat to the Fed remains an economic or credit crisis. History is clear that the Fed’s current actions are once again behind the curve. Every rate hike puts the Fed closer to being unwelcome “event horizon.”

“What should be of greatest concern to the Fed and the Treasury Department is the worsening demand for US debt auctions. A key measure called the bid-to-cover ratio of the government’s offer on Wednesday was $32 billion on benchmark 10-year notes was more than one standard deviation below last year’s average.Bloomberg News.

When the lag effect of monetary policy collides with accelerating economic weakness, the Fed will realize its mistake.

A crisis in the Treasury market is likely to be bigger than the Fed realizes. So, accordinglyto Bloomberg, there are already potential plans for the Government to participate and buy back bonds.

“When we warned last week that Treasury purchases could begin to enter the debt management conversation, we didn’t expect them to suddenly jump into the limelight. Liquidity strains in September may have sharpened the Treasury’s interest in buybacks, but this is not just a knee-jerk response to recent market developments.

If something breaks in the Treasury market, it’s probably time to buy the same stocks and long-term Treasuries as next. “Fed or Treasury Put” returned.

By Lance Roberts via

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